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Dreadful Stocks to Avoid

Never forget rule No. 1.

Warren Buffett's first rule of investing is: "Never lose money." To this, he often adds rule No. 2: "Never forget rule No. 1." Of course, following these rules is easier said than done. But Buffett's done pretty well, so it seems unwise to simply dismiss his advice as the semi-coherent ramblings of a man who's read way too many 10-Ks.

I take those rules to heart in my investment strategy. I try to focus my investment dollars on sustainable, undervalued businesses that I can easily understand. Buffett has made more than $40 billion for himself using that strategy, and he's made even more for his partners and shareholders over the years. Do you really need to assume a lot of risk to make more than $40 billion? My answer, and the answer of my colleagues at Motley Fool Inside Value, is "Heck, no!" If I make only $40 billion, I'll be perfectly satisfied.

People spend a lot of time discussing the companies Buffett buys. But in the spirit of not losing money, it's equally worthwhile to understand the types of businesses that Buffett does not buy in order to steer clear of potential duds. I see five main categories:

1. Businesses that bet the farmIn some industries, companies occasionally have to make critically important decisions. If the company makes the wrong choice, it will be dealt a crippling blow. This is terrible for a shareholder, because even if the company makes the right decision one month, it might fail to do so the next. There's no "three strikes and you're out" policy. One strike, and it's game over -- your money's gone.

2. Businesses dependent on researchIt's quite reasonable to believe that research can be a competitive advantage for certain companies. In fact, one reason Genzyme(NASDAQ:GENZ) has been so successful over the long term is that it has devoted so much to top-notch research and development. Nevertheless, there is a downside to research. Often, innovative companies are required to do research simply to maintain their competitive position. And if the research dries up, the company suffers, which is what short-term holders of the company may be experiencing now.

For instance, consider the plight of Bristol-Myers Squibb(NYSE:BMY). Like many of the huge pharma companies, Bristol-Myers had a long and impressive history of earnings growth because of new breakthrough products and a promising pipeline. But in that past eight years or so, Bristol-Myers has been unimpressive -- and has lost to the overall market. Thanks to various problems with the company's pipeline and the immense regulatory hurdles the company has to clear thanks to the Food and Drug Administration, shareholders of Bristol-Myers are not being properly rewarded.

This is in stark contrast to a company like FedEx(NYSE:FDX), which could develop nothing for a decade and still have a very healthy business that can reward shareholders. While I don't think this is sufficient reason to sell off all your tech or biotech stocks, I can understand why Buffett avoids such investments.

3. Debt-burdened companiesIn general, Buffett avoids companies with a lot of debt. This makes sense. During the best of times, large amounts of debt mean that cash that could be put toward growing the business or rewarding shareholders is instead servicing the debt. In a crisis, debt greatly limits a company's options and can sometimes lead to a bankruptcy filing.

A more subtle point is that great businesses throw off piles of cash. Great businesses generally don't need to use huge amounts of debt leverage to achieve an acceptable return for shareholders. So, if a company needs debt to achieve reasonable returns, it's less likely to be a great business. You can see this with numerous airlines, and one like Delta in particular. Delta has billions of dollars in debt at levels that exceed its market cap. More importantly, it relies on this debt to build out its ability to serve the customer -- it's a necessity. Not all airlines are quite as burdened: For example, Southwest(NYSE:LUV) and, to some extent, JetBlue(NASDAQ:JBLU) are sitting on relatively better capital structures. But now that all airlines are sitting in a horrible consumer spending environment, the ones that carry a lot of relative debt must shoulder that load while trying to compete in a miserable competitive landscape. It's not a good situation, especially as an investor.

4. Companies with questionable managementManagement has incredible power. If executives want to enrich themselves at the expense of shareholders, either directly or by misrepresenting the company's prospects, individual shareholders have almost no hope of stopping them. I strongly recommend avoiding companies where there's even a hint that management lacks integrity. Some clues to look for here include excessively optimistic press releases, overly generous compensation or options grants, and frequently blaming external circumstances for operational shortcomings. WorldCom and Enron shares may have risen for years, but at the end of the day, shareholders received almost nothing. That's why I think questionable management is the worst flaw a company can have.

5. Companies that require continued capital investmentOver the long term, shareholders make spectacular returns by buying businesses that are able to achieve extraordinary returns on capital. This leads to excess capital that the company can use to repurchase shares, pay a dividend to shareholders, or reinvest in further growth. Companies that constantly need to make additional capital investment to keep the business going are the antithesis of this ideal -- the main beneficiaries will be employees, management, suppliers, and government. If you're sitting on one of the big banks these days (whether it's Citigroup(NYSE:C) or Bank of America(NYSE:BAC)), you better be prepared for continued capital investment to support the companies' respective balance sheets. Without properly understanding the quality of these banks' underlying assets, it's impossible to know how safe your position really is. And more to the point, future capital infusions (regardless of whether they come from public or private sources) may help the banks, but they certainly don't help you as a shareholder.

The upshotThese characteristics don't necessarily make a company a bad investment.Johnson & Johnson, for instance, has been a great long-term investment despite ongoing research and development and capital expenditures. But a solid understanding of why these types of companies may be undesirable can help you identify whether a company that looks good on the surface might actually cost you money later.

We use similar techniques at Inside Value. With every stock, we cautiously evaluate each of these factors -- focusing on competitive advantages, potential threats, the balance sheet, and anything we can glean from SEC filings -- to determine whether the business is likely to provide a solid return for shareholders. In our initial recommendation of any company, we discuss the risks the company faces and provide updates when new risks appear on the horizon. By focusing on great businesses and understanding the potential risks of any company, we endeavor to achieve Buffett's first rule -- "Never lose money." To see the companies we've identified, take a 30-day guest pass to Inside Value. There's no obligation to subscribe.

This article was originally published on Oct. 7, 2005. It has been updated.

Fool contributor Richard Gibbons has forgotten what rule No. 2 is. He does not have a position in any of the companies mentioned in this article. FedEx is a Motley Fool Stock Advisor pick. Johnson & Johnson is an Income Investor pick. The Motley Fool has a disclosure policy.